Tips from Warren Buffett’s mentor

Warren Buffett's deep-value approach to investing got him into trouble, says Alex William. Then his mentor, Charlie Munger, gave him some sage advice.

Investment tutorials often promise to teach you how to "invest like Warren Buffett". But you should pay at least as much attention to Buffett's partner, Charlie Munger, who Buffett credits with transforming his investment style. Previously, Buffett was a "deep value" investor, looking for dirt-cheap stocks that still had some value to be eked out of them. This got Buffett into trouble in the 1970s, as he bought into the US textile industry, which only looked cheap because it was failing. Munger persuaded him to pay up for better-quality stocks with higher returns, such as Coca-Cola.

"It's hard for a stock to earn a much better return than the business which underlies it," says Munger. "If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return, even if you... buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive-looking price, you'll end up with a fine result."

The most important number

return on capital employed (ROCE)

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The other half of the equation is profit measured as earnings before interest and tax (EBIT). Dividing one by the other gives the ROCE: a firm that generates a $20m profit from capital of $100m has a ROCE of 20%. It's best not to look at the metric for just one year; a one-off bumper profit might distort the figure too high. But a company with consistently high ROCE has a strong chance of consistent growth.

The ROCE figure contains a mountain of information. A business with hefty debts, such as National Grid, employs a lot of capital in its business model, so the ROCE is almost always low. The same goes for a business with low margins, such as Tesco. But most importantly, ROCE tells you how much a company needs to invest to generate its profit. The trouble with capital-hungry industries, such as banks and utilities, is that they require huge investment to grow meaningfully. Even when it has turned a profit, water group Severn Trent has rarely achieved a ROCE above 10%.

As such, even a relatively large investment in its asset base will only generate a modest rise in profit. By comparison, companies in nimbler sectors, such as advertising groups or budget retailers, requirerelatively little fresh investment to keep growing. Budget retailer Poundland had a 49% ROCE last year, reflecting how little it spends on opening new shops, versus the margins it generates. Metal-bashing manufacturers, such as Weir or BAE Systems, usually sit somewhere in between.

Hunting down knock-out companies

Consumer-goods stocks such as Unilever and Nestl have less stellar returns, but trump other sectors on consistency, explaining why they are seen as such stalwarts. Next week, I'll be looking at four British manufacturing stocks with consistently high ROCE that have been sold off hard in the recent turmoil.